Not-A-Pundit: The Renaissance

Social Security Taxes Lower Fertility, Family Formation February 5, 2007

WASHINGTON (Dow Jones)–Economists have long held that demographic trends, namely the comparatively small size of the generation following the 80 million strong, soon-to-retire Baby Boomers, are the root of Social Security’s long-term financing woes.

But a recent academic paper argues instead that it is the system’s pay-as-you-go tax structure – in which retiree benefits are paid by current workers – that caused the decline in fertility rates in the first place, and warns that raising taxes more to bring the system into better fiscal balance would only make matters worse.

The pay-as-you-go Social Security system has “independently contributed to (declining marriage and fertility rates), and thus, ironically, to the system’s growing financial vulnerability,” Isaac Ehrlich of the University of Buffalo and Jinyoung Kim of Korea University say in a paper released last week by the National Bureau of Economic Research.

It’s a bit of a chicken-and-egg question whether demographics put pressure on Social Security’s finances or vice versa. But the issue is more than just academic. With reform of Social Security and other entitlements generating greater buzz in Washington, how the problem is defined will go a long way in determining what types of changes are acceptable.

Ehrlich and Kim estimate that Social Security taxes account for more than one-quarter of the decline in U.S. fertility rates since 1950. For countries in the Organization for Economic Cooperation and Development as a whole, Social Security taxes account for almost half the drop in fertility rates, the authors say.

In the U.S., Social Security benefits are funded via a 12.4% tax on wages up to $97,500 split between employees and employers – though some economists say workers bear all of the tax since the employer share is passed on to them in the form of lower wages.

When the Depression-era Social Security program was founded, favorable demographics meant benefits could be paid to retirees without onerous taxes on workers. In Social Security’s early days there were about 15 workers per retiree, meaning the program could be financed with a combined payroll tax rate of just 2% – a fraction of what it is today. But steadily rising life expectancies and lower birthrates in the U.S. has meant that there are now only about 3 to 4 workers per beneficiary.

Ehrlich and Kim say that by putting distance between family formation and retirement benefits, the current Social Security financing structure has created a disincentive to form families.

Since benefits are defined broadly and not based on what each family’s own children contribute, the system can “induce unintended consequences” that are “not socially optimal,” they say in their paper.

“Since defined benefits are independent of contributions made by children, parents are not compensated individually for raising more or better-educated children,” according to the authors.

As a result, payroll taxes “diminish the incentive of individual workers to bear and invest in children, save for retirement, or generally form families altogether, because they lower the private rewards from family investments relative to alternative individual pursuits,” they say.

The paper therefore supports those who argue that higher taxes aren’t the way to balance Social Security. Without a fix, Social Security is on schedule to go bankrupt by 2040, when the number of retirees swamps the system’s ability to pay benefits. The fiscal crunch will begin far sooner however, as the amount of Social Security benefits eclipses the amount of revenue the government collects in the next decade.

Reform ideas generally include some mix of higher taxes, reduced benefits and an increase in the retirement age.

The White House says it is willing to listen to all ideas on entitlement reform, but President George W. Bush has been resistant to lifting Social Security taxes.

Higher taxes “could actually exacerbate the downward trends in key demographic variables, even if it could alleviate the financial burden on (pay-as-you-go) systems in the short run,” Ehrlich and Kim say in their paper.

The White House’s 2007 budget, released Monday, reflects Bush’s plan to let workers use some of the Social Security payroll tax to fund voluntary retirement accounts. Beginning in 2012, workers would be able to use up to 4% of their Social Security taxable earnings, up to a $1,300 yearly limit, to fund the accounts. That would cost $29.3 billion in 2012.

“The President continues to believe that this is part of the answer to Social Security, particularly for younger people,” Rob Portman, director of the Office of Management and Budget, said Monday.